Low Risk, High Return

When it comes to investing in the stock market there are a wide variety of approaches to choose from, yet at the end of the day the motive is always the same: profit. In general the rule is that the higher the return you desire, the greater the risk you must take. And while that’s generally true, it is a mistake to assume that high risk always equals high return. The other fallacy that stems from this is that lower risk strategies necessarily offer poor returns.

Partly there is an issue of semantics here; the formal definition of risk is quite distinct from the colloquial notion. And of course, terms such as high or low return are relative. Nevertheless it seems that many investors are largely ignorant of what constitutes a decent return and as such are often lured into chasing speculative, high risk stocks and strategies in the belief that it is the only path to success. The irony of course is that those that adopt such approaches often end up with very average or even negative returns, (which is perhaps unsurprising given all the risk that they have exposed themselves to!)

The fact is that investors can achieve very satisfactory investment returns in the share market with a focus on companies with relatively low risk profiles. That is, companies that have an established track record of financial performance, and the confidence and commitment to share returns with shareholders in the form of dividends. To appreciate why such stocks are worth getting excited about, you need to grasp two fundamentals of wealth creation: exponential growth and time.

Wheat and Chess

Exponential growth is well explained by the allegory of the grain of wheat and the chessboard. In one telling, the inventor of the game of Chess so pleased the King with his invention that he was asked to name his reward. Being a wise man he asked that on the first day he receive one grain of wheat for the first square on the chess board. On the second day he requested two grains for the third square, then four grains for the next square, and so on such that on each successive day, the following square would receive twice as many grains as the previous square, and this would continue for 64 days until all squares received their allotted quota. The King happily agreed, believing that the reward would prove to be extremely modest. You can guess the rest...

By the 64th day, the inventor would receive 9.2 thousand trillion grains of wheat! In total, with all the other squares, he would receive over 36 cubic kilometers of wheat, or roughly 80 times the annual harvest if all of Earth's arable land could be devoted to wheat! The point is that while it may take a while for things to get going (after 10 squares you still only have a cup or two of grains), the rate of growth inevitably proves to be mind-bogglingly huge.

The relevance of this for investors is that equities tend to experience exponential growth over time, due to the effects of compounding returns.

The rule of 72

A useful way to understand the significance of annual rates of return is through doubling time; that is, the time it will take for an investment to double in value, given a set rate of annual return.

Doubling time can be easily approximated using the rule of 72. This states that if you divide 72 by the annual percentage growth rate you will get the time it takes to double your investment. So for example, if you had a share that grew by 15% each year, your investment would double in less than 5 years. Put another way, after 10 years you would experience a more than 4 fold increase in value. Probably not what you would expect for a modest 15% annual rate of growth.

Chasing rainbows

And yet many investors take ridiculous risks by focusing on speculative companies and using highly leveraged instruments because they covet returns well above this. But as has already been pointed out, that requires taking greater risk, which of course means greater potential for loss. But greed has a funny way of blinding us to rational thought, and so it’s easy to find yourself chasing rainbows in the share market.

In my view, it is far better to target more realistic returns in the market. Not only because they are far more likely to be realized, but also because they will, given time, lead to very attractive investment returns anyway.

Take a longer view

This of course requires the foresight and patience to allow your investments to grow, but as behavioral finance studies reveal, we are terrible at imagining things too far in the future. Ten years sounds like a long stretch of time and most of us are more concerned with our returns from one year to the next. (I would however ask you to consider how fast the last ten years went by). As such we underestimate, by far, the significance of average annual rates of return.

The truth is that there are literally dozens of large blue chip stocks that have managed to more than double in value over the past 10 years in Australia, despite the GFC. All those listed below had a market cap of at least one billion back in 2000, and the vast majority were all established, profitable, dividend paying stocks.

What’s also worth noting is the importance of dividends over this period. On average, dividends alone provided a 73% return, and yet none of these stocks had yields that you would consider exceptional back in 2000. What I haven’t done is to calculate what the returns would be if dividends were instead reinvested along the way; but I can assure you the gains would be even more remarkable.

Keep it real

My point is simple: excellent returns are possible in the market without unacceptable risk. It just takes a focus on the right stocks and an appreciation of the importance of time in the market.

Yes, you could choose to chase unproven, speculative companies and trade with highly leveraged instruments, and there is a (very) small chance you could quickly make a fortune. Alternately, you could look to build a portfolio of established, viable businesses. You will almost inevitably experience plenty of ups and downs along the way, and there is little chance that such an approach will generate large short term gains. But it is the end result that matters.

In ten year’s time I suspect many punters will still be chasing that elusive ‘killer trade’, and taking unacceptable risks in pursuit of that goal. Yet if we can appreciate the significance of average and achievable rates of growth, if we can allow our investments the time needed to really grow, if we can stop worrying about what is happening day to day or week to week, then we stand a very good chance of building real and enduring wealth over our working lives.

And that in a nutshell is the premise behind the DividendKey course. (Don’t let the word ‘dividend’ fool you into thinking this is about income investment for retirees. The DividendKey is as much about growth as income, and very attractive growth at that). Risk may very well equal return, but low risk doesn’t have to imply low return.

Make the markets work for you!

Make the markets work for you,

Andrew Page